Derivatives Essay

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A Discussion of Financial Economics in Actuarial Models A Preparation for the Actuarial Exam MFE/3F Marcel B. Finan Arkansas Tech University c All Rights Reserved Preliminary Draft October 10, 2011 2 To Pallavi and Amin Preface This is the third of a series of books intended to help individuals to pass actuarial exams. The present manuscript covers the financial economics segment of Exam M referred to by MFE/3F. The flow of topics in the book follows very closely that of McDonald’s Derivatives Markets. The book covers designated sections from this book as suggested by the 2009 SOA Syllabus. The recommended approach for using this book is to read each section, work on the embedded examples, and then try the problems. Answer keys are provided so that you check your numerical answers against the correct ones. Problems taken from previous SOA/CAS exams will be indicated by the symbol ‡. This manuscript can be used for personal use or class use, but not for commercial purposes. If you find any errors, I would appreciate hearing from you: mfinan@atu.edu Marcel B. Finan Russellville, Arkansas May 2010 3 4 PREFACE Contents Preface Parity and Other Price Options Properties 1 A Review of Options . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Put-Call Parity for European Options . . . . . . . . . . . . . . . . 3 Put-Call Parity of Stock Options . . . . . . . . . . . . . . . . . . . 4 Conversions and Reverse Conversions . . . . . . . . . . . . . . . . . 5 Parity for Currency Options . . . . . . . . . . . . . . . . . . . . . . 6 Parity of European Options on Bonds . . . . . . . . . . . . . . . . 7 Put-Call Parity Generalization . . . . . . . . . . . . . . . . . . . . 8 Labeling Options: Currency Options . . . . . . . . . . . . . . . . . 9 No-Arbitrage Bounds on Option Prices . . . . . . . . . . . . . . . . 10 General Rules of Early Exercise on

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